5 EcoNews: A Special Report Por Asociación de Industriales de Puerto Rico On February 4th, Standard & Poor s Ratings Services cut its rating of Puerto Rico s general obligation debt to BB+ from BBB-, pushing it to the highest junk level status. 1 It also downgraded the Commonwealth s appropriation secured debt and Employee Retirement System debt to BB, as well as lowered various ratings on the Puerto Rico Highways and Transportation Authority to BB+ and the Development Bank (GDB) to BB. It refrained from taking a rating action on sales tax-secured debt of the Puerto Rico Sales Tax Financing Corp. (COFINA), but maintained its negative outlook on its COFINA ratings. Table I: Credit History of Puerto Rico Within a few days, the other credit agencies, Moody s and Fitch, followed with their own credit downgrades, as the decision by S&P, plus economic factors, notwithstanding the measures enacted by the government to manage the situation, weighted heavily in their decisions. 2 The Economy These developments have serious implications for the performance of the economy, as they give more weight to the possibilities of a more pronounced contraction than originally estimated for fiscal years 2014 and The outlook for the economy in the case of GNP growth becomes more negative, considering also the observation made by S&P (2014) that The Commonwealth may also potentially need monthly cash flow financing in fiscal 2015, following use of a $1.2 billion of credit line draws for cash flow purposes in fiscal Moreover, recently Moody s, for instance, estimated that if Puerto Rico s credit were downgraded, it faced $1.0 billion in short-term costs due to collateral calls on loans that are contingent on P.R. s debt not being rated junk. 4 An additional downside risk is the effect of the downgrade on the financial system. Recently, S&P lowered the ratings of three financial institutions (Santander, FirstBank and Popular Bank), on the basis of a weak economy that can deteriorate lending activity, affecting the profitability of several of these institutions, plus the exposure of some to government loans. The analysis of past, and recent trends of the selected economic indicators, up to the last quarter of 2013 shows that the local economy continued to face growth challenges. Employment, retail sales, bankruptcies, delinquency rates and cement sales point to an economy that suffered a contraction during fiscal 2014, above that announced by the Puerto Rico Planning Board last October. The situation is expected to deteriorate as a result of the most recent S&Ps downgrade to junk level by S&P of P.R. s general obligation debt to BB+ from BBB-. The Debt in Numbers As of fiscal 2013, it is estimated that the total circulating public debt of Puerto Rico amounted to $70.2 billion, of which $65.7 billion corresponded to the gross debt of the central government, corporations, municipal, constitutional and extra-constitutional, and COFINA (which account for 24.5% of the debt, and public corporations 47.0%). As an indicator of high public indebtedness, Continúa en la página 6 5

6 Viene de la página 5 gross public debt represented 90.4% of the island s GNP (nominal), from 58.4% in fiscal 2000, edging down from 93.2% in fiscal Total circulating debt represented 97.0%, from 100.7% in fiscal Graph IV: Annual Growth of Nominal GNP, General Fund Net Revenues, and Total Gross Public Debt (Fiscal Years *) Graph I: Gross Public Debt and Total Circulating Public Debt Graph II: Ratio of Total Gross Debt in Circulation and Gross Public Debt to GNP After the downgrades Expectations in the short and medium term will be influenced by the downgrades that, although expected, will nevertheless have its impact on consumers, businesses, and through the fiscal situation of the government, on public spending and investment. GNP growth will thus face strong downside risks during fiscal years 2015 and To have an idea of how the situation deteriorated, between fiscal years 2001 and 2013, the net increase in the gross public debt amounted to $43.0 billion, of which $31.7 billion was incurred during the period This accounted for 74.0% of the increase in net indebtedness during the period. The net increase in the debt of COFINA accounted for 39.0% of the $31.7 billion increase, debt that was issued, in essence, to cover current and recurrent spending. Graph III: Annual Increases of Gross Public Debt In the wake of Standard & Poor s decision to cut Puerto Rico s credit rating to junk, the governor announced on February 5th several measures to cut the budget deficit. The Bill, E , submitted to the Legislature, included several proposals, among them an amendment to the current budget (Fiscal year 2014) to reduce the deficit by $170 million without laying-off public employees, and requiring 2.0% expense cuts by central government agencies, except the Department of Education. 5 This is coupled with the efforts already implemented to reduce spending, including public payroll. At the same time, the government will continue to negotiate loans whose payments have been accelerated by S&P s decision $575 million in 90 days and $375 million in less than six months and in financing alternatives to provide greater liquidity to the GDB. On the revenue side, the administration has indicated that it is completing the revised revenue projections without new taxes for the next fiscal year, taking into account the economic growth projection and income measures already legislated, together with the efforts to control tax evasion. On the economic side, the government has identified $800 million in public and private investment in infrastructure projects that it will push aggressively. Thus, while during the years , the economy (production) expanded at a nominal rate of growth of 4.4%, and government revenues (net) barely increased, by 1.6%, the size of the public debt increased 8.5% annually. Nevertheless, the negative economic impact will be strong, at least in the short and medium term. The expected contraction in public spending and investment will lower economic growth perspectives. For incoming fiscal 2015, the government has already announced a reduction of $820.0 million in spending in order to eliminate the deficit. Continúa en la página 7 6

7 Viene de la página 6 Table II: Projections On the other hand, of the new GO issue contemplated for next month for $3.5 billion, most of it will go to pay old debt ($2.0 billion), an amount that would not provide monies further than 2015 and none for investment. The proceeds are also to be used to terminate interest-rate swaps, fill a $245.0 million hole in the current fiscal year s budget, and bolster the liquidity of the Government Development Bank. Interestingly, some analysts are of the opinion that despite the risk, there is demand for fresh debt from Puerto Rico, especially among sophisticated investors seeking high returns. Hedge funds and other alternative asset managers believe they see ways of protecting themselves in the face of an increasing risk that Puerto Rico s other debt will have to be restructured at some point. 6 The impact on the manufacturing sector of the downgrades is somewhat more difficult to pinpoint. Obviously, those sub-sectors related to construction will be impacted, as will those that produce for the local market. To the extent that it produces for export, the direct impact should be minimal. Any impacts will be in the mid and long terms, through a more restrictive tax environment and costly infrastructure services. Expanding exports from both the manufacturing and service sectors is essential for stimulating economic growth since local markets will remain weak for at least the next three to four years. The main implication of the current crisis is the need for Puerto Rico to adopt an outward orientation in its economic initiatives. Real GNP growth accumulated rate of 4.3% during fiscal years 2014 and 2015, and public investment by 29.7%, as its main source of funds, debt, will be heavily constrained. The most recent downgrade by Fitch on February 17th of PRSA s credit rating and of the PRPA s to junk level, following Moody s decision on February 10th, will simply make it more difficult (and costly) for these two key public corporations to entertain an expansion in their investment. 8 Private investment in construction will continue to be on the downside, led by a housing sector still in the doldrums, and a scarcity of public funds for investment. It is estimated that it will contract at an accumulated rate of 27.8% during fiscal years 2014 and 2015, with fiscal 2016 still on the negative side, -6.4%. Graph V: Annual Growth Rates: Historic and Forecasts Graph VI: Annual Averages Real GNP Growth: Historic and Forecasts In the case of real GNP growth, our revised forecasts take into consideration the potential effects of the rating downgrade by S&P, for the balance of current fiscal 2014, but its impact will be also felt in coming fiscal The contraction will extend into fiscal years 2014 through 2016, as the economy is estimated to have contracted by -2.0% this fiscal year, and -2.5% in fiscal 2015, slowing down still in fiscal 2016 by -1.0%. 7 As a result of the expected limitations in revenues and deficit financing, public spending is expected to contract at an Continúa en la página 8 7

8 Viene de la página 7 On balance, expect the next three fiscal years to continue on a contraction mode, slightly more pronounced on average than in the previous three years. Public Measures steps in the right direction? The government has initiated or enacted a series of measures to restore fiscal balance, liquidity to the GDB, and the proposed revision of the tax system, submit a real balanced budget for fiscal 2015, are steps in the right direction. Nevertheless, they entail spending cuts, less money for investment, and again raising revenues, which in essence will be of taxes, and user fees for services. All, one way or the other, will impact consumers and businesses, eroding domestic demand. And none of these options are too appealing. There is still the issue of the proposed reform to the Teachers Retirement System, whose implementation is pending on a decision by the local Supreme Court. An unfavorable one would send the wrong signals to the bond market and investors. In the short and medium term, the measures proposed or to be enacted will help to regain credit standing and confidence, but they will take time. 9 Immediately, and into next fiscal year, the situation will be quite constrained, as explained before. Notes: 1. Standard & Poor s Rating Services (2014). Puerto Rico GO Rating Lowered To BB+ : Remains on Watch Negative, Rating Direct (February 4). At: www. stndardandpoors.com/ratingsdirect. 2. There is a question about what might happen with Moody s Investors Service and Fitch Ratings following S&P s downgrade. That might force selling by investors who have mandates preventing them from holding junk-rated debt. On February 7th Moody s downgraded two notches its ratings to Ba2 from Baa3 with outlook negative. See Moody s Investor Services (2014), On February 11th Fitch did the same with a downgrade to BB from BBB- with negative outlook. See Fitch Ratings (2014), https://www.fitchratings. com/creditdesk/press_releases/detail.cfm?pr_id=820231&origin=home&cm_ sp=homepage-_-featured_content_archive-_-fitch%20downgrades%20 Puerto%20Rico%20to%20%27BB% Standard & Poor s Rating Services (2014), p Cnbc.com (2014). Why Puerto Rico Needs to Borrow Money Soon, (January 24). At: 5. The legislation seeks to amend Articles 3 and 8 of Law This Law created in 2013 the Fiscal Reconstruction Fund, under the custody of the Department of the Treasury, and authorized the Government Development Bank to transfer to the Fund $245.0 million to finance the administration s economic development plan known as the Jobs Now Act. 6. M. Williams and M. Corkery (2014), Puerto Rico Wants to Incur More Debt to Regain Financial Footing, DealB%K (February 18). At: com/blogs/dealbook/2014/02/18/puerto-rico-wants-to-incur-more-debt-toregain-financial-footing/?smid=fb-share. 7. The estimates are subject to revision, once the Planning Board publishes its macroeconomic estimates for fiscal 2013, and revised 2012, expected in March, and the annual benchmark revisions of nonfarm employment data that will be available in March from the U.S. BLS. 8. Fitch Ratings (2014). Fitch Downgrades Puerto Rico Aqueduct & Sewer Authority Senior Revs to BB+ ; Outlook Remains Negative (February 18). At: https://www.fitchratings.com/creditdesk/press_releases/detail.cfm?pr_ id=820922; Fitch Downgrades Puerto Rico Electric Power Auth s Revs to BB+ ; Outlook to Negative (February 18). At: https://www.fitchratings.com/ creditdesk/press_releases/detail.cfm?pr_id= Some analysts believe that it will take Puerto Rico within five years to regain its investment grade rating from S&P. See S. O Leary and M. Shellhorn (2014), What Does Below Investment Grade Mean for Puerto Rico?, Nuveen Asset Management (February), p. 4. At: Documents/Default.aspx?fileId= Noticias de Estudios Técnicos, Inc. Durante el mes de marzo, personal de Estudios Técnicos, Inc. participó en las siguientes actividades: 4 de marzo - Se ofreció una conferencia en un seminario auspiciado por el Colegio de CPAs y UBS sobre las implicaciones de la degradación para las cooperativas de ahorro y crédito. 5 de marzo - Se ofreció una conferencia a ejecutivos de una de las principales empresas multinacionales del sector de la construcción. 6 de marzo - Graham Castillo ofreció una charla a clientes de Oriental sobre oportunidades de negocio. 6 de marzo - Se ofreció una conferencia sobre las perspectivas económicas a los ejecutivos de una importante empresa farmacéutica. 7 de marzo - Se preparó una ponencia para el foro sobre la Ley de Cabotaje auspiciado or la Pontificia Universidad Católica en Ponce. 12 de marzo - Se participó en la Junta de Directores de la Fundación de Microfinanzas. 13 de marzo - Se participó en la conferencia de prensa en que se presentó el Informe de la Comisión de Descentralización y la Creación de Regiones Autónomas, del cual Estudios Técnicos, Inc. fue el principal consultor. 14 de marzo - Se participó en la reunión del Concilio de Concertación. 21 de marzo - Se presentó una conferencia sobre perspectivas económicas a la Asociación de Ejecutivos de Cooperativas. 27 de marzo - Se participó en la reunión de la Junta de Gobierno de Fondos Unidos de PR. 28 de marzo - Se participó en un panel sobre perspectivas económicas de la Asociación de Patronos de Carolina. 8

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